OUTLOOK 2007: PRICES AND SUPPLY

Will 2007 finally unravel our oil mysteries?

By year-end, there will be data to either dispel peak oil worries or more precisely determine whether a peak is occurring.

Matthew R. Simmons, Simmons & Company International, Houston

A year ago, in this same outlook column, I warned that 2006 would be a challenging year for oil markets as demand continued to grow, notwithstanding growth constraints imposed by limited spare capacity. It is tempting to simply repeat last year’s story, since little has changed to brighten the outlook for sustained growth in high-quality oil supplies. The rig and personnel shortages I discussed as 2005 ended have worsened over the past 12 months. The industry’s entire value chain of complex assets, which are needed to bring crude oil and natural gas liquids from the wellhead to a consumable petroleum product, is effectively operating at full capacity. Moreover, a high percentage of energy infrastructure is far too old, and only a tiny portion of this value chain is being replaced.

Last year was challenging for global oil markets. A year ago, oil prices had retreated from post-hurricane highs. This retreat led many astute oil market observers to note that oil prices finally peaked at the height of the panic caused by two freak hurricanes. Conventional oil wisdom began to preach that growth in oil demand was clearly slowing down, and many new projects were finally coming onstream to ease the supply tightness that had plagued oil markets for the prior three or four years.

It took only a matter of months before oil prices broke back above $70 a barrel. By early August, oil prices spiked to just under $80 a barrel. Then suddenly, prices began another wild, free-fall decline. Within six to seven weeks, the price of US motor gasoline and diesel fuel had fallen by one-third. Crude oil prices followed in this wake, and, by early November, oil prices were below $60 a barrel for the first time since the hurricane season ended in 2005.

As oil prices fell, those who had steadfastly predicted a return to normal low oil prices felt a sense of vindication, as could be seen from many media interviews.

Chevron and Devon’s announcement of the Jack II appraisal well that flow tested for 30 days and opened up the Lower Tertiary in the deepwater Gulf of Mexico, the deepest formation to ever be tested there, was seemingly a seminal event. What followed was a frenzy of excitement largely stimulated by a host of leading oil observers who proclaimed that Jack field had possibly created a new Prudhoe Bay, and could potentially increase US oil reserves by as much as 50%. This “new oil supply” was seen as further evidence that the era of high oil prices was over.

As crude oil and finished product prices fell, more oil observers were stunned by the bulge in reported crude oil, motor gasoline and diesel inventories. Oil-at-sea was deemed to be close to glut levels. OPEC oil ministers began to fret that OPEC needed to quickly cut production in order to support $60 per barrel.

Lost in all the chaos the price decline created was a realistic assessment of what reported US petroleum stocks were signaling. What caused the surge in gasoline stocks was the complex transition of replacing reformulated gasoline (RFG)—which, by law, would be obsolete by the end of 2006—with Gasoline Blendstock for Oxygenate Blending (RBOB), which is blended with ethanol at the terminal rack, not at the refinery.

The entire rise in stocks was simply due to filling up the “pipeline” with a new stock not yet in full use, while the system still needed to keep RFG production sufficient to meet record gasoline use. Once the new RBOB product was in place, RFG stocks began a swift decline. Few oil observers seemed to take note of this. Instead, the same choir singing “oil prices will decline” began to note an even more rapid build in diesel stocks.

This rise was spectacular but was entirely due to the second fuel-specification change underway: The supply of 15-ppm, ultra-clean diesel fuel had to increase for truckers’ use by October. Once this inventory build was in place, the over-15 and under-500 ppm diesel stocks began to plummet.

In neither case was there any evidence that usable inventories of gasoline or diesel, which collectively feed American drivers with 12 million to 13 million bpd of transportation fuel, were in excess supply. It was simply an illusion caused by the need to “double stock” during this unique change-over in both gasoline additives and clean diesel. Crude stocks remained high, particularly relative to ultra-low stocks post-Katrina and -Rita a year earlier, as refineries struggled to complete long overdue, turnaround maintenance programs.

By early December, the industry’s most astute analysts finally took note that, over a nine-week period, reported US crude oil, gasoline and diesel stocks had fallen by close to 65 million barrels, bringing stocks back to extremely low levels based on days of use.

The industry now seems to take these wild price gyrations in stride as normal behavior for commodities. But these gyrations are not normal for an industry that is as capital-intensive as the oil industry has become. Swift price rises get blamed on fear factors, hedge funds and speculators. When prices then fall, the decline too often is assumed to signal glut. The volatility now appears to have come close to destroying any reliable price signals that efficient market theorists assume generally always work.

A far more noteworthy event in 2006 was when non-OPEC, non-Former Soviet Union oil supplies stayed mired in a rut at 36–37 million bpd for the seventh consecutive year. Had the FSU not made an unplanned and surprising boost in its oil production from 2000 through 2006, rising from 7.9 million bpd in 1999 to 12.05 million bpd in 2006, the world would not have been able to meet the inexorable and vigorous growth in oil demand.

Another surprise was the consistently strong growth in oil demand, despite prices staying above $70 a barrel for a good part of the year. It is hard to now believe that so many oil experts assumed that global oil demand had probably peaked in the early 1990’s, after global demand had stagnated for seven years, staying in a narrow range of 66–68 million bpd. In retrospect, this was one more failure on the part of a growing chorus of “oil experts” simply glancing at the bottom line number and failing to see that contracting demand from the FSU was fully offsetting growing demand from most of the rest of the world. The latest guess is that the average 2006 global oil demand will work out to 84.5 million bpd, with 4th-quarter 2006 demand hitting an all-time record 86.2 million bpd.

What makes these demand numbers even more astonishing is that FSU demand is still around 4 million bpd, down from peak demand of almost 11 million bpd set at the end of the 1980s. A well known energy “fact” was how quickly oil demand would wane, if prices ever got to seemingly stratospheric levels. This myth was proved untrue in 2006. In fact, the higher oil prices rose, the faster demand grew.

Many long-term forecasts point to oil demand reaching 120–130 million bpd by 2020 to 2030. This increase in demand comes primarily from rapidly developing or non-OECD economies of the world. Non-OECD countries comprise two-thirds of the world’s population, and the per capita oil use of these countries is small when compared to Europe, Japan and the US.

The problem with this rapid growth is the unlikely chance that supply could suddenly start growing as quickly as demand. Too many key producing countries are now in what seems to be irreversible decline. This list now includes countries like the UK, Norway, Colombia, Indonesia, Egypt, Syria and Yemen. Mexico has joined this list, as its giant Cantarell field is already in (14% last year) a steep decline, now that its tertiary recovery program is over.

The list of growing oil producers is clearly getting small. It includes Brazil (until its early deepwater fields begin to decline), Azerbaijan, Angola, Algeria, Equatorial Guinea, the Sudan and Chad. But all of these oil producers, collectively, would have a hard time growing production by 4–5 million bpd.

The big supply mystery remains Russia and the Middle East. Russia’s government seems intent on wresting significant control over its oil assets. Some of the hard-nosed oil experts in the Kremlin seem set to prevent Russia from risking another painful production collapse by over-producing its mature fields or too quickly draining any new oil fields.

The Middle Eastern oil story is still “an enigma wrapped inside a maze of imperfect data.” Iran’s oil minister recently warned that without significant new investment and new oil finds, Iran’s key mature oil fields will decline by 13% per year. Another study released at the end of 2006 warned that Iran’s ability to export oil might end by 2014, as declining production and increasing domestic oil use erode export capacity.

A year ago, a senior Kuwait oil executive announced that Burgan, once the second largest oil field in the world, was exhausted after six decades of producing over 2 million bpd and needed lower production rates to extend oil production for as long as possible. Elsewhere, the UAE sold ExxonMobil 28% of its offshore giant, Upper Zakum field, in return for ExxonMobil’s technical skills in managing oil production from mature fields.

Saudi Arabian oil is being pumped furiously—2006 saw the highest rig count in the Kingdom’s history—triple the rigs that were at work only four years ago. Saudi Aramco continues to ramp up spending on both exploration and more development wells. In late December, Saudi Aramco announced spending on development well drilling will increase 60% in 2007, to almost $4 billion. The state oil giant will spend another $620 million on exploration, out of a total capital budget of $15.8 billion in 2007. Four extremely ambitious rehabilitation projects are underway to vastly expand oil output from fields found decades ago. In a perfect world, these projects would re-create 12.5 million bpd of productive capacity, but some of the improved output merely replaces declines of about 8% per year in mature fields.

The only solid data outside of Saudi Arabia on what the Kingdom actually produces and how much comes from each of its six-to-eight key fields, comes from the IEA’s monthly reports of oil imported into the IEA member countries. Over the last few years, Saudi Arabia’s crude oil exported into the OECD had barely changed, while the OECD’s total imported crude has grown by more than 2 million bpd. Whether this indicates that the Kingdom is now struggling to keep its oil production flat, while it boasts of producing almost 2 million bpd more than it did in 2002, will remain a secret until Saudi Arabia leads the world into genuine energy data reform and begins producing timely field-by-field quarterly production reports.

The world was short of high-quality drilling rigs as 2006 began. By year-end, this scarcity had grown and now limits many company project plans for 2007 and beyond. The backlog of new rigs-on-order grows, but few were actually delivered in 2006, and the problem of finding skilled workers is more complex today than a year ago.

The cost of sizable new oil projects and the time to get them completed has also increased markedly. Reports of project overruns of $5 to $10 billion are now so common they hardly make much press coverage. Few of these massive projects create long-term peak oil output, and few generate as much as 200,000 bpd at peak output.

As I predicted a year ago, 2006 became the year when the topic of peak oil intensified. Whether it is starting to reach the scale of global warming is still unclear. Cambridge Energy Research Associates (CERA), in a publicly released report entitled Why the ‘peak oil’ theory falls down: Myths, legends, and the future of oil resources begins a surprisingly polemic attack on peak oil believers by stating “The peak oil debate continues to rage without any obvious progress.”

By the end of 2007, there will be far more powerful data to either dispel the urgency of peak oil worries or to nail down with far greater precision how likely it might be that peak oil is occurring. The world’s crude oil supply, excluding NGLs, other hydrocarbons and refining processing gains, now struggle to stay in a 73 to 74 million bpd range. At the end of 2005, total crude supply briefly exceeded the 74 million bpd level. It now takes over 10 million bpd of other sources of petroleum or petroleum substitutes to meet record demand. These other sources are as hard to grow as oil has become.

The world should begin to better sense whether any OPEC producer has the wherewithal to grow its oil output by even 33% over the next few years. If non-OPEC, non-FSU oil output is still stuck below 37 million bpd, this should put to rest any further belief that the past seven years were a string of bad luck and instead, a sure sign that this key source of almost half the world’s oil has peaked.

A prominent wild card for 2007 is how the industry copes with an asset base that is now too antiquated and too rusty, and whether it is even possible to quickly begin rebuilding all the rusty pipes, tankers, tank farms, gas processing plants and drilling rigs that are so crucial to keep oil supply intact.

Oil prices will likely stay volatile, but the risk seems heavily tilted toward higher price spikes unless some supply relief is quickly created or demand growth finally stops. 

THE AUTHOR
	Matthew R. Simmons, Chairman and CEO of Simmons & Company International, graduated cum laude from the University of Utah and received an MBA with distinction from Harvard Business School in 1967. He served on the faculty of Harvard Business School as a research associate for two years and was a doctoral candidate. After five years of consulting, he founded Simmons & Company International in 1974. The firm has played a leading role in assisting energy client companies in executing a wide range of financial transactions. He is a trustee of The Museum of Fine Arts, Houston, and The Farnsworth Art Museum in Rockland, Maine. He serves on the boards of several industry and civic groups. He is past chairman of the National Ocean Industry Association, and he serves on the board of the Associates of Harvard Business School, and is a past president of the Harvard Business School Alumni Association. Mr. Simmons' papers and presentations are published regularly in a variety of publications and oil-and-gas industry journals, including World Oil.